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Monday, May 23, 2016

How the Fed Could Break the Economy

Stocks continue to move sluggishly at the beginning of this week with the Dow Jone Industrial Average moving at a flat 0.08 percent today. The S&P 500 and the Nasdaq indices are just as uninteresting with movement around the nil mark today as well. Trends in either direction have flatlined with daily market fluctuations stabilizing to a tight trading range. The limp movements have caused just a -0.74 percent change in the S&P 500 index, a change from more volatile times. As oscillations have dampened, the VIX volatility index has risen 6.4 percent over the past five days to add on to a monthly gain of 10.94 percent total. It seems that with no clear direction, the stock market has entered a very tense position where neither bulls nor bears show that they have the trend in their favor. In these situations, bears often win out.

The U.S. manufacturing PMI came out today with an expectation of 51 or higher for the month of May. Unfortunately, the index came in lower at 50.5 losing 0.3 off of April's reading of 50.8. The news erased any chances of early gains for the S&P 500 sending daily trading below yesterday's close by midday. Afternoon trading looks more promising as traders are likely to break even by the end of the day. The falling manufacturing index certainly does little to justify the recovery from the early 2016 losses as it reaches its lowest levels since late 2012. Fundamentally, the metric points to a weakened supply base that has been optimistically traded to highs before the minor crashes in August and January. Have we seen the through? Higher stock prices might only be salvaged by a reversal in the latter part of 2016. At the moment, there are only two things we know. First, the manufacturing sector is very weak right now with lagging domestic and international demand causing supply slowdowns. Second, the manufacturing sector has the potential to improve its fundamentals with mid-2014 highs around 58. Longs will be hoping for an increase in inflation to spur an increase in inventories. Contrarians are pooling their bets with the bears citing this index as support for their position.

Industrial production growth has been equally as disappointing with the lowest levels seen since the financial crisis. While data for May have not come out yet, estimates may be around -1 percent for the month as a slight recovery from the lows in late 2015 looks viable. Ever since September 2015, monthly growth has been below zero as a fundamental contraction stretches into 2016. In the face of these negative industrial growth rates, investors have continued to value industrial shares with a high level of earnings potential. Using the industrial production index produced by the Federal Reserve, we can see how investors have valued the U.S. industrial sector using the Dow Jones Industrial Average. Plotted above is a DJIA-to-industrial-production ratio over the past year and a half. After building throughout 2014, a resistance at 170 is where investors held their evaluations before crashing in the months of August and January to the mid-150's which is where the ascent began in January 2014. March and April of this year both had readings about 170 which could signal another devaluation to come in the near-term. Speculation without supporting fundamentals rarely goes unpunished.

Leading indicators, on the other hand, support a near-term bullish outlook with The Conference Board's "Leading Economic Index" growing by 0.6 percent in the month of April. This index typically peaks before stock market peaks as they measure expectations for future fundamentals. Recently, the growth of the metric has slowed over 2015 and 2016 hinting at a long-term peak in the economic cycle. In fact, the indicator is reaching levels seen only during the boom in 2005 and 2006, before the stock market crash in 2008. A slowing LEI might deter some long-term bullish entries while causing short-term traders to rush for last minute profits before the indicators signal something worse.

For now, eyes and ears will be fixed on the Federal Reserve with governors and analysts pitching their opinions on a potential rate hike during the June 15th meeting. Of particular interest were comments made by St. Louis Federal President James Bullard a member of the party set to cast their votes in about three weeks. In an interview, he predicted that a "tight labor market in the United States may put upward pressure on inflation" making a case for higher interest rates stronger. According to the CME Group's FedWatch tool, the probability of a rate hike sits at 30 percent up from 26.3 percent before the Fed President's comments. While a majority of investors are expecting economic pressure to force another pass, many are coming to terms with the need for a normalization of monetary policy. The Fed's inflation projections support the conditions for these policies to be adopted.

By 2017, the Fed hopes to increase the Federal Funds rate faster than flattening inflation. This will give the effect of increasing real interest rates which can be contractionary if the economy is not growing sufficiently. If inflation does increase by 1.2 percent by the end of 2016, the Fed should be able to continue with a normalizing of policy to a Fed Funds rate of 1.4 as the real effect will be a 0.2 decrease in real interest rates. These calculations are currently guiding the hand of the Federal Reserve as they want to be careful to maintain a balance in tightening the money supply and allowing inflation to return to its long-term target. Oil price movement, which is closely related to inflation fluctuations, will have more of an effect on Yellen's team than ever before as one slip back into the $30's could spell disaster for the global economy.

There are many signs that point to a sluggish economic outlook that could endanger the current recovery. The Federal Reserve will play an integral role in the upcoming months as it begins to raise interest rates above the near-zero levels which they are at now. Increasing rates too quickly or failing to normalize in time could end in another mini-crash like August and January. Based on the track record of Yellen's troupe, I wouldn't bet on things running as smoothly as they should. Not only do the Federal Reserve members have to move concisely and cohesively, but they must work with the world's monetary institutions to create the right atmosphere for fundamentally sound growth. For that reason, meetings in June and July will be very important events coming up this summer.